For decades, the principle of nexus—the idea state governments cannot tax a person or business without them having a physical presence in the state—has been enforced. Now, however, many states—including Alabama, South Dakota, and, most recently, Tennessee—are challenging the physical-presence standard because they want to collect sales taxes on transactions made on the internet.

Under a new rule proposed in October 2016 by the Tennessee Department of Revenue and supported by Gov. Bill Haslam (R), “Out-of-state dealers who engage in the regular or systematic solicitation of consumers in this state through any means and make sales that exceed $500,000 to consumers in this state during the previous twelve-month period also have a substantial nexus with this state,” according to the bill’s text.

Unless the state legislature moves to block the new rule during its 2017 session, sellers over the sales threshold will be required to register with the Department of Revenue by March 1, 2017, and they will need to start enforcing, collecting, and remitting the tax on sales made to Tennessee consumers on July 1, 2017.

Tennessee’s proposal faces significant legal hurdles, including the precedent set by the U.S. Supreme Court’s 1992 decision in Quill Corp. v. North Dakota. In that case, the Court determined a state must prove a company has a “substantial nexus” within a state before taxes can be imposed. Since this ruling, the nexus, or “physical presence standard,” has been an important taxpayer protection.

If Tennessee moves forward with the proposed rule, it would expand the power of state governments over retailers operating outside their borders, including the imposition of different auditing requirements. Not all states tax sales the same, which is problematic; different state tax definitions and rules are likely to lead to confusion for out-of-state buyers and sellers.

Removing the physical presence standard for sales taxes would reduce Tennessee’s accountability to taxpayers and enables a dramatic expansion of state taxing powers. “Once the online sale of real goods is taxed, it will be only a matter of time before digital products, such as iTunes, apps, ring-tones, digital books, and movies will also be taxed,” wrote John Nothdurft, The Heartland Institute’s government relations director, in a Policy Tip Sheet. “States will see the Internet as a practically unlimited source of tax income by charging low rates on large numbers of transactions.”

Supporters of online taxes argue these taxes are needed to restore a balance between online and bricks-and-mortar retailers. But the imposition of sales taxes on internet sales would slow the growth of the e-commerce industry, one of the few sectors of the economy that has seen growth in recent years. In addition, requiring online retailers to charge a sales tax in states in which they do not have a physical presence would force consumers to pay a tax to a government with which they have no political voice and from which they receive no government benefits or services.

Instead of forcing out-of-state businesses to serve as government tax collectors, state legislators should implement a sales tax system based on where the product was sold, known as an origin-based tax system. This would truly level the playing field because online and brick-and-mortar retailers would pay the same tax.

The following documents examine state internet sales taxes in greater detail.

An “Original” Solution to Taxation of Online Saleshttps://www.heartland.org/publications-resources/publications/an-original-solution-to-taxation-of-online-sales?source=policybot
Writing for the American Legislative Exchange Council, Andrew Moylan discusses the origin-based sourcing rule for internet sales taxes and explains how it solves many of the problems created by destination sourcing: “Perhaps the most important advantage of origin sourcing, however, would be the infusion of tax competition it could engender. Under such a system, businesses would have an incentive to invest in lower-tax jurisdictions so as to attract price-conscious customers.”

Marketplace Fairness: Leveling the Playing Field for Small Businesshttps://www.heartland.org/publications-resources/publications/marketplace-fairness-leveling-the-playing-field-for-small-business?source=policybot
In written testimony before the U.S. Senate Commerce, Science, and Transportation Committee, Kelly Cobb of Americans for Tax Reform discusses remote-state sales tax collection and physical presence in light of the proposed Marketplace Fairness Act. “The effects on taxpayers of the Marketplace Fairness Act and similar legislation would be dramatic,” Cobb said. “From a taxpayer perspective, any bill that touches remote sales taxes must preserve the physical presence standard and protect consumers on net from a higher tax burden. Unfortunately, the federal online sales tax bills miss the mark widely on both fronts.”

Nothing in this Research & Commentary is intended to influence the passage of legislation, and it does not necessarily represent the views of The Heartland Institute. For further information on this and other topics, visit the Budget & Tax News website, The Heartland Institute’s website, and PolicyBot, Heartland’s free online research database.

The Heartland Institute can send an expert to your state to testify or brief your caucus, host an event in your state, or send you further information on a topic. Please don’t hesitate to contact us if we can be of assistance! If you have any questions or comments, contact John Nothdurft, Heartland’s director of government relations, at jnothdurft@heartland.org or 312/377-4000.